III. Claims of the Parties

1. The claim of the European Communities is that both the Transitional System and the New Chilean System are inconsistent with Chile's obligations under GATT Article III:2, second sentence.
2. The European Communities claims that³⁹:

1. the Transitional System, which is applicable through 30 November 2000, is contrary to GATT Article III:2, second sentence, because it provides for the imposition of lower internal taxes on pisco than on other directly competitive or substitutable imported spirits which fall within the tax categories of "whisky" and "other spirits", so as to afford protection to Chile's domestic production;
2. the New Chilean System, which will become applicable as of 1 December 2000, is also contrary to Article III:2, second sentence, because it results in the imposition of lower taxes on pisco with an alcohol content of 35° or less than on other directly competitive or substitutable imported spirits which have a higher alcohol content, so as to afford protection to Chile's domestic production. ⁴⁰

3. In response, Chile contends that the New Chilean System is fully consistent with Article III:2 because it taxes all distilled spirits, regardless of type and regardless of whether imported or domestic, according to identical objective criteria of alcoholic strength and value (ad valorem).
4. Chile then claims that this Panel should reject the unwarranted and intrusive interpretation of the reach of Article III that the European Communities has put forward in this dispute, and that in keeping with the plain language and the history of Article III, the Panel should find that the New Chilean System is fully consistent with Article III:2, second sentence.
5. Chile also argues that to the extent that the Panel considers the Transitional System to be at issue notwithstanding the short time in which it will remain in effect, it would be appropriate for the Panel to find that pisco is not directly competitive or substitutable with other distilled spirits in Chile, and hence that the Transitional System also conforms with Article III:2, second sentence.

IV. Arguments of the Parties

A. Overview

1. GATT Article III:2, second sentence

1. The European Communities puts forth the relevant GATT provision, GATT Article III:2, second sentence, which reads as follows:

Moreover, no Member shall otherwise apply internal taxes or other internal charges to imported or domestic products in a manner contrary to the principles set forth in paragraph 1.

2. Further, the European Communities refers to Article III:1, which provides in relevant part that:

The Members recognize that internal taxes ... should not be applied to imported or domestic products so as to afford protection to domestic production.

3. The European Communities then indicates that the Interpretative Note to Article III:2 states that:

A tax conforming to the requirements of the first sentence of paragraph 2 would be considered to be inconsistent with the provisions of the second sentence only in cases where competition was involved between, on the one hand, the taxed product and, on the other hand, a directly competitive or substitutable product which was not similarly taxed.

4. The European Communities further points out that in Japan - Taxes on Alcoholic Beverages II⁴¹, the Appellate Body clarified that in order to determine whether an internal tax measure is inconsistent with Article III:2, second sentence, it is necessary to address the following three issues:

1. whether the imported products and the domestic products are "directly competitive or substitutable products" which are in competition with each other;
2. whether the directly competitive or substitutable imported and domestic products are "not similarly taxed"; and
3. whether the dissimilar taxation of the directly competitive or substitutable imported products is "applied ... so as to afford protection to domestic production".

5. In addition, the European Communities points out that as a preliminary matter it must be ascertained whether the measures at issue are "internal taxes". The ILA is levied on all distilled spirits intended for consumption in Chile, whether locally manufactured or imported, and not just "on" or "in connection" with the importation of distilled spirits. Accordingly, the ILA constitutes an "internal tax" in the sense of GATT Article III:2, and not an "import charge" within the purview of GATT Articles II and VIII.
6. Chile, while agreeing that the proper basis for analyzing whether a measure conforms with Article III:2, second sentence, is the test set out in the ruling of the Appellate Body in Japan - Taxes on Alcoholic Beverages II, points out that concerning these three elements, the Appellate Body in Japan - Taxes on Alcoholic Beverages II emphasized that:

[T]hese are three separate issues. Each must be established separately by the complainant for a panel to find that a tax measure imposed by a Member of the WTO is inconsistent with Article III:2, second sentence. ⁴²

7. Chile then argues that the EC complaint does not and could not meet this three-part test. Chile asserts that the European Communities, perhaps out of habit based on arguing about the Japanese and Korean tax systems, devotes the largest part of its argumentation to the first part of the three-part test: the question of whether pisco is directly competitive or substitutable with other spirits in the Chilean market. Chile does not agree that the European Communities has met its burden with respect to the first element. However, the issue of directly competitive or substitutable, which was at the core of the disputes concerning the Japanese and Korean systems of taxation, is essentially irrelevant in the analysis of the New Chilean System, because the new system eliminates all distinctions based on type of distilled spirits. Instead, the New Chilean System applies an identical system of taxation to all types of distilled spirits, regardless of whether they are like, competitive or substitutable and regardless of origin.
8. In response, the European Communities contends that Chile's strategy in this case is to divert the Panel's attention from the examination of Chile's own tax system. Chile attempts to do so by focusing the discussion on other tax systems (both real and hypothetical), which are fundamentally different from the New Chilean System. With the same purpose, Chile tries to focus the debate on a number of superficial differences between this case and previous cases.
9. According to the European Communities, Chile has good reasons to follow this strategy. Indeed, the New Chilean System does not withstand a close examination in light of the three-prong test established by the Appellate Body in Japan � Taxes on Alcoholic Beverages II.

2. Transitional System

10. With respect to the Transitional System, the European Communities states that from 1985 to November 1997 pisco was taxed at the rate of 25 % ad valorem, whereas whisky, the main imported distilled spirit, was taxed at the rate of 70 % and "other spirits" (a residual category comprising all distilled spirits other than pisco and whisky) at the rate of 30 %.
11. The European Communities argues that in an attempt to address longstanding complaints from the European Communities and other WTO Members, Chile amended its liquor tax system in November 1997, following protracted discussions between its Government and the local pisco industry and a lengthy debate by the Chilean Congress.
12. According to the European Communities, the New Chilean System approved in November 1997 will not take effect until 1 December 2000. In the meantime, the previous system will remain in place, with the only difference that the tax rate on whisky will be progressively lowered from 70 % to 53 %.
13. The European Communities argues that the Transitional System, which is applicable until 30 November 2000, is contrary to GATT Article III:2, second sentence, because it provides for the imposition of lower internal taxes on pisco than on directly competitive or substitutable imported spirits that fall within the tax categories of "whisky" or "other spirits", so as to afford protection to Chile's domestic production.
14. Chile replies that the EC complaint about the Transitional System, in effect, seeks to replicate previous EC complaints about Japanese and Korean systems of alcohol taxation. Chile notes that by invoking the analysis of the Appellate Body in Japan - Taxes on Alcoholic Beverages II, the European Communities argues, among other things, that in Chile all distilled spirits are directly competitive or substitutable.
15. Chile goes on to state that, with respect to the Transitional System, it believes that there are significant differences of fact and law between this case and the cases of the Japanese and Korean systems that were found inconsistent with Article III:2. While all three systems make distinctions based on type of distilled spirit, there is much less difference in taxation under the Transitional System, and there are much stronger bases for considering that pisco is not competitive or substitutable in the Chilean market with any other type of spirit.

3. New Chilean System

16. The European Communities argues that the New Chilean System that will become applicable as of 1 December 2000 is also contrary to Article III:2, second sentence, because it results in the imposition of lower taxes on pisco with an alcohol content of 35° or less than on directly competitive or substitutable imported spirits which have a higher alcohol content, so as to afford protection to Chile's domestic production.
17. The European Communities asserts that the New Chilean System abolishes only as a formal matter the distinction between pisco and the other types of distilled spirits. Instead, the applicable rate varies according to (but not proportionally with) alcohol content. Specifically, all spirits with 35° of alcohol content or less are taxed at the rate of 27 % ad valorem. From that base, the rate escalates by 4 percentage points for each additional degree of alcohol content, peaking at 47 % for all distilled spirits above 39° . Thus, for a mere five degrees increase in alcohol content, the applicable rate nearly doubles. In contrast, similar differences in alcohol content, both above and below the 35° -39° bracket, do not entail any difference in taxation at all.
18. The European Communities thus concludes that the New Chilean System is designed to continue to afford protection to pisco at the expense of imported distilled spirits. In fact, approximately 90 % of pisco is bottled at 30° to 35° and, therefore, will be taxed at the lowest rate of 27 %.
19. The European Communities further argues that in contrast, all imports of whisky, rum, gin, vodka and tequila (which together account for more than 95 % of all imports of spirits into Chile) will be taxed at the highest rate of 47 %. Furthermore, unlike pisco those spirits do not have the flexibility to move down the scale. Under Chilean law, all of them must be bottled at no less than 40° and, therefore, are automatically locked in the highest rate of 47 %.
20. According to the European Communities, the protective effects of the New Chilean System are by no means incidental. The lack of internal coherence of the new system (as revealed in particular by the spasmodic progression of the tax rates) evidences that the tax differentials serve no legitimate purpose. Alcohol content has been chosen as a taxation principle simply because it provides a basis for replicating indirectly the protective effects of the old system, and not because the new system is genuinely aimed at discouraging alcohol consumption.
21. Chile replies that the New Chilean System, in terms of Article III:2, "similarly taxes" all distilled spirits, regardless of type. All distilled spirits are taxed according to the objective, neutral criteria of alcohol strength and value (ad valorem). The European Communities notes that low alcohol pisco will bear less tax than high alcohol scotch whisky, but that effect of the Chilean system is no more inconsistent with Article III:2 than is the higher tax that high horsepower U.S.-built cars may face in Europe relative to small European cars.
22. Chile contends that a violation of Article III has not occurred merely because, by some measurements, an imported product bears a higher tax than even a like domestic product, if the difference in the tax is not based on nationality of the product and results from the application of objective criteria. As will be demonstrated below, the European Communities itself has conceded in past WTO cases that neutral, objective criteria such as value (ad valorem) and alcohol content are permissible bases for a neutral tax system.
23. Chile points out that implicitly, the European Communities also concedes the legitimacy of an alcohol content system in this case as well, but the European Communities still tries to argue that the Panel should require still more: that the differentiation in ad valorem tax be directly and evenly proportional to the differences in alcohol content. There is no such requirement in the language or history of Article III:2.
24. According to Chile, while the European Communities tries to give the impression that this is just one more complaint about taxation of alcoholic beverages in the mold of recent cases such as those involving Japan (twice) and Korea, that is not the case. The New Chilean System is very different from those alcohol tax systems successfully challenged in the past in that the New Chilean System does not distinguish by type, but rather applies identical objective critieria to all products. Chile argues that the European Communities is asking the Panel to expand the interpretation of Article III in ways that are unprecedented and unwarranted.
25. Chile also indicates that the major distilled spirits exporting companies and countries have enjoyed success in past cases in challenging tax laws where there was explicit discrimination based on national origin of the products or where, as in the case of the Japanese and Korean systems, the favored product was of a type that effectively could only be domestic. Now the European Communities asks this Panel to go further to ban tax distinctions based on the neutral criterion of alcohol content, at least if the distinction is not directly proportional to the difference in alcohol content. For the European Communities, it is apparently not sufficient that taxes not discriminate by national origin or by type, nor is it sufficient that the results of the application of the neutral criterion will favor some imports as well as domestic products and disfavor some domestic products as well as imports. Finally - and perhaps most significantly - the European Communities ignores the fact that the use of this objective criterion of alcohol content will enable foreign and domestic producers alike to adapt their products in a very simple process (dilution with water) if they wish to obtain the most favored tax treatment.
26. Further, Chile states that if the Panel accepts the EC reasoning, it would not be a far step from such an interpretation to strike down national standards that, though based on objective criteria and applied without regard to national origin, had the effect of being less convenient or more burdensome for many foreign producers than for many domestic producers.
27. Accordingly, Chile concludes that this Panel should reject the unwarranted and intrusive interpretation of the reach of Article III that the European Communities has put forward in this dispute. Instead, in keeping with the plain language and the history of Article III, the Panel should find that the New Chilean System is fully consistent with Article III:2, second sentence.

B. "directly competitive or substitutable"

1. Overview

28. The European Communities argues that pisco and the other distilled spirits are "directly competitive or substitutable".
29. In response, Chile argues that the European Communities has not established that other distilled spirits are directly competitive or substitutable with pisco. Chile does not deny that there is some degree of substitutability among various distilled spirits, but Chile disagrees that this degree is large enough so as to fall within the directly competitive or substitutable products in the Chilean market, within the meaning of Article III:2 second sentence.
30. Chile goes on to claim that the EC arguments on this point are at least relevant (though unpersuasive) with regard to the Transitional System, which imposes different rates of taxation based on type of distilled spirit. However, the question of whether the different types of distilled spirits are directly competitive or substitutable does not arise in the New Chilean System. The liquor tax systems of Japan and Korea examined by WTO panels involved tax structures organized around product type. The New Chilean System is an entirely different system where differentiation in taxation is based on alcohol content, not type of distilled spirit.

2. General Consideration

31. The European Communities begins with the argument that the scope of "directly competitive or substitutable" products is broader than that of "like" products. Products which may be too different in terms of physical characteristics or end uses to qualify as "like" for the purposes of the first sentence of Article III:2 may still be found to be "competitive or substitutable" for purposes of its second sentence. ⁴³
32. The European Communities points out that in Japan - Taxes on Alcoholic Beverages II, the Appellate Body ruled that the terms "like product" must be construed "narrowly" in the first sentence of Article III:2. ⁴⁴ This interpretation was deemed necessary in view of the fact that, as put by one of the complainants in that dispute, Article III:2, first sentence, operates as "guillotine": once it has been established that two products are "like", any tax differential between them is deemed prohibited, without it being necessary to ascertain whether the tax differential is applied "so as to afford protection".
33. Further, the European Communities notes that the Appellate Body arrived at its conclusion that the term "like" should be construed "narrowly" as follows:

Because the second sentence of Article III:2 provides for a separate and distinctive consideration of the protective aspect of a measure in examining its application to a broader category of products that are not "like products" as contemplated by the first sentence, the European Communities agrees with the Panel that the first sentence of Article III:2 must be construed narrowly so as not to condemn measures that its strict terms were not meant to condemn. Consequently, the European Communities agrees with the Panel also that the definition of �like products' in Article III:2, first sentence, should be construed narrowly. ⁴⁵

34. The European Communities also states that, in contrast, there is no suggestion in Japan - Taxes on Alcoholic Beverages II that the notion of "directly competitive or substitutable" product must also be construed "narrowly". This reflects the different wording and structure of the second sentence of Article III:2. Unlike the first sentence, the second sentence makes express reference to the first paragraph of Article III. This means that in order to establish a violation of Article III:2, second sentence, it must be determined first, as one of three separate requirements, that the tax differential is "applied ... so as to afford protection to domestic production". Therefore, a "narrow" reading of the terms "directly competitive or substitutable", unlike a "narrow" interpretation of the terms "like product", is not required in order to ensure that only protectionist measures are condemned.
35. According to the European Communities, the drafting history of the GATT 1947 also supports a broad interpretation of the scope of "directly competitive or substitutable" products. At the Geneva session of the Preparatory Committee, delegates cited several examples of products that could be considered sufficiently "competitive" to trigger the application of Article III:2, second sentence. These examples included quite broad categories of products, such as apples and oranges⁴⁶; linseed oil and tung oil⁴⁷; and synthetic rubber and natural rubber. ⁴⁸ The record discloses that no disagreement was expressed by delegates with respect to the breadth of these examples. At the Havana Conference, some delegates mentioned even larger categories of products, such as tramways and busses or coal and fuel as examples of "directly competitive or substitutable" products. ⁴⁹
36. The European Communities argues that past panels which have interpreted the notion of "directly competitive or substitutable products" have also taken a broad approach. The Panel Report on Japan � Taxes on Alcoholic Beverages I ⁵⁰ found that shochu and all other distilled spirits were directly competitive and substitutable on the Japanese market. This finding was confirmed in Japan � Taxes on Alcoholic Beverages II.
37. Also, the European Communities points out that another example is provided by the Panel Report on EEC � Measures on Animal Feed Proteins, which concluded that vegetable proteins and skimmed milk powder were "directly competitive or substitutable" products for the purposes of applying the second sentence of Article III:5. ⁵¹
38. Chile contends that despite the slight and temporary practical effect of the issue whether pisco is directly competitive or substitutable with any other distilled spirits, at least as a matter of precedent, it is important to emphasize that the European Communities has failed to substantiate its claim that pisco is directly competitive or substitutable in the sense of Article III with European spirits.
39. Chile goes on to state that the European Communities has been careful to include many paragraphs and even some charts purporting to fulfill each of the elements necessary to demonstrate that other distilled spirits are directly competitive or substitutable with pisco in the Chilean market. The Panel should not simply accept the EC's contentions which, in the view of Chile, do not stand up to close scrutiny as proofs that the products are directly competitive or substitutable. Chile notes that the European Communities has provided what are undoubtedly thick studies and annexes, and the Transitional System has some superficial similarities to the Japanese and Korean cases. Chile urges the Panel to reject the EC's arguments. Accepting the EC's contentions regarding the Transitional System would set an adverse precedent that would constitute yet one further significant step toward requiring harmonization of taxation of increasingly disparate products - even as panels continue to claim that such is not their objective or intent.
40. Chile then states that the Panel should instead find that the European Communities has failed to meet its burden of demonstrating that pisco is directly competitive or substitutable with other distilled spirits in the Chilean market.

To continue with Potential Competition

³⁹ The European Communities notes that in its panel request, it also claimed a violation of GATT Article III:2, first sentence. The European Communities states that even though certain spirits exported from the European Communities to Chile (including in particular certain types of brandy) may be considered as being "like" to pisco, it decided not to pursue that claim, given that those spirits are in any event "directly competitive or substitutable" with pisco.

⁴⁰ The European Communities argues that the New Chilean System already constitutes mandatory legislation, and as such, it may be the subject of dispute settlement under the WTO Agreement, citing Panel Report on United States � Taxes on Petroleum and Certain Imported Substances, BISD 34S/136, paras. 5.2.1-5.2.2.

⁴¹ Appellate Body Report on Japan � Taxes on Alcoholic Beverages (hereafter, "Japan - Taxes on Alcoholic Beverages II"), adopted on 1 November 1996, WT/DS8/AB/R, WT/DS10/AB/R, WT/DS11/AB/R, p. 24. See also the Appellate Body Report on Canada - Certain measures concerning Periodicals (hereafter "Canada - Periodicals"), adopted on 30 June 1997, WT/DS31/AB/R, pp. 24-25.

⁴² Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p. 24 (emphasis added by Chile).

⁴³ Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., p. 25.

⁴⁴ Ibid., pp. 19-20.

⁴⁵ Appellate Body Report on Japan - Taxes on Alcoholic Beverages II, supra., pp. 20-21. The European Communities points out that the Panel Report on Japan - Taxes on Alcoholic Beverages, (hereafter, "Japan � Taxes on Alcoholic Beverages II"), adopted on 1 November 1996, WT/DS8/R, WT/DS10/R, WT/DS11/R, para. 6.22 states: "Giving a narrow meaning to �like products' is also justified by the inescapability of violation in case of taxation of foreign products in excess of [sic] domestic products".

⁴⁶ E/PC/T/A/PV/9, p. 7.

⁴⁷ E/CONF.2/C.3/SR.11, p.1 and Corr. 2.

⁴⁸ E/CONF.2/C.3/SR.11, p. 3.

⁴⁹ E/Conf.2/C.3/SR.40, p. 2. Nevertheless, the European Communities notes that unlike in the case of the examples mentioned at Geneva, there was some disagreement among delegates with respect to these examples.

⁵⁰ Panel Report on Japan - Customs Duties, Taxes and Labelling Practices on Imported Wines and Alcoholic Beverages, BISD 34S/83 (hereafter, "Japan � Taxes on Alcoholic Beverages I").

⁵¹ Panel Report on EEC � Measures on Animal Feed Proteins, BISD 25S/49, para. 4.3.